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13

A. The Impact on the Domestic Economy

Reducing the income tax rate increases the opportunity cost of leisure. Domestic households therefore substitute out of leisure and into consumption. The impact of this substitution effect is shown in Figure 1(a) and 1(b): both domestic output and consumption increase. These results are consistent with the analysis of real business cycle models. Baxter and King (1993), for example, look at the impact of an exercise symmetric to ours, finding symmetric results: a balanced-budget increase in public spending financed by income taxes reduces both output and consumption in their model.

As Figure 1(g) shows, domestic real revenue collection permanently falls by about 3 percent compared to its initial steady-state level as a consequence of the policy that we are analyzing. Figures 1(e) and 1(g) show that, although a lower income tax rate increases labor supply, the impact of this on income and total revenue collection is not big enough to compensate for the rate reduction. For the reasons discussed above, real consumption increases following the income tax reduction. This implies that consumption tax revenue collection increases in real terms even at an unchanged consumption tax rate. However, the quantitative impact of the increase in consumption tax collection is small (Figure 1(g)). The change in total real tax collection can be explained with reference to equation (22). Since the consumption tax rate

does not change in this policy exercise (τˆC = 0) , the change in real consumption tax

ˆ collection is given by (1u)Ct . The low initial share of consumption taxes in our

benchmark parameterization ((1u) = 0.3)) explains why the impact of an increase in real

consumption tax collection is not big enough to prevent a strong decrease in overall real tax collection.

In terms of nominal tax collection, there is no consumption tax impact under our parameterization. Since we have fixed the consumption elasticity of money demand to unity, and we keep nominal money supply fixed, equation (10) implies that changes in nominal consumption and prices are mirror images of each other. Nominal collection of consumption

t a x t h e r e f o r e d o e s n o t c h a n g e . I n t e r m s o f e q u a t i o n ( 2 1 ) 0 ˆ = C τ , a n d t C ˆ a n d t P ˆ o f f s e t e a c h

other.

Table 1. Income tax rate cut: tax revenues collection changes 1/

t=1

t=3

t=5

-4.2

-3.5

-3.5

Change in nominal tax revenues

New steady state

  • -

    3.5

t=1

t=3

t=5

-3.7

-2.9

-2.9

Change in real tax revenues

New steady state

  • -

    2.9

1/ Percentage changes with respect to the initial steady state.

Table 1 summarizes the impact on tax collection of a change in the income tax rate at various time horizons. As it is clear from Figure 1 and Table 1, in our model the minimum necessary condition for dynamic Laffer effects—that following a reduction in tax rates today taxes will be higher at some point in the future in the absence of further policy changes—is not satisfied. Since no dynamic Laffer effects arise in our model, it is clear that tax cuts do not

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